How do Banks Calculate Interest Rates?

May 10, 2018 by AmwalCom

Over time, borrowing a loan from a bank has grown easier. In
the past, it used to be a long tedious process that required a pile of
documentation and a series of approvals. Nowadays, people can request a loan
from any bank and receive it by the next day. The principle of loaning is
rather appealing; borrowing a decent amount of money and paying it off
gradually is like a dream come true, up until the word "interest" comes into
play.

What is interest and how do banks determine its
percentage? Investopedia
defines interest as ‘the charge for the privilege of borrowing money’. To put
it simply, interest is the bank’s annual fees for lending you the money. On what basis is the interest rate calculated?

To understand the mathematics of the interest rate on your
loan, first you have to learn about the two main types of interest: flat
interest and reducing interest.

1.
Flat interest rate means a fixed
charge paid on the original amount of the loan, also called the principal. This is usually the
case with car loans/finance.

Let’s say that you decided to borrow a loan of 50K JOD from a bank. The
interest rate this bank offers is a flat interest rate of 10% to be paid on a yearly
basis for five years. This means that every year, you will be paying an extra
amount of 5K JOD equally distributed over installment payments. Given that the loan period is
five years (60 months), the monthly payment for the loan in the previous
example would be 75,000 JOD/60 months = 1,250 JOD
The question is: how much of the
monthly payment (1,250 JOD) goes for interest?
To answer this question, you ca
use the equation below: Interest payable per instalment
= (Original
Loan Amount x Number Of Years x Interest Rate Per Annum) ÷ Number Of
Instalments

The monthly interest paid =
(50,000 JOD * 5 Years * 10%) / 60 =417
JOD (833 JOD is paid for the loan)Not a big fan of numbers? Try out our Loan Calculator by
visiting the type of loan you’re interested in.
2.
Reducing interest rate: this
interest is based on the amount of outstanding payment that is remaining with
the passing of every year, i.e. the interest rate decreases after each year
(except in cases with default in payment). Taking the same example, a 10%
reducing annual rate on the 50K dinar loan planned to be paid over a period of
five years is as follows:

First year: the interest to
be paid over the year sums up to 5K JOD. Second year: the interest
is 10% of the remaining outstanding amount. Since 10K JOD of the loan is paid,
40K are left. Therefore, the second year’s interest rate amounts to 4K JOD.
Third year: By the 3rd
year, 30K JOD are left è 10% * 30K = 3K JOD of interest is applied. By the last year of
payment, you will have to pay 1K JOD of interest instead of 5K JOD as in
the case of flat rate.

Finally, you should be careful when taking a loan, whether
with a flat or reducing interest rate. Read the terms and conditions carefully
and cross-check the items more than once. There isn’t a standardized loaning
system for all banks. Therefore, check with a consultant and ask lots of
questions if needed.

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